With regulators increasing their focus on Environmental, Social and Governance (ESG) matters, Cian Higgins, Head of Quantitative Solutions examines regulator moves in the area of ESG Risk Management.
In recent months the European Banking Authority (EBA), the European Central Bank (ECB) and the Central Bank of Ireland (CBI) have demonstrated increased focus on Climate and Environmental (C&E) risks within the banking sector. This is evident from the release of key regulatory documents to increasingly regulate anticipated C&E risks. Below is a snapshot of some of those released:
- November 2021 – ECB released “The state of climate and environmental risk management in the banking sector”.
- A comprehensive assessment of 112 Significant Institutions across Europe and their progress against 13 supervisory expectations with respect to C&E risk was released in November 2020.
- November 2021 – CBI issued a Dear CEO letter “Supervisory Expectation of Regulated Firms regarding climate and other ESG Issues”.
- January 2022 – EBA released “Final draft implementing technical standards on prudential disclosures on ESG risks in accordance with Article 449a CRR”.
- January 2022 – ECB launched the 2022 climate stress test and macro-financial scenarios.
- January 2022 – ECB released SSM Supervisory Priorities for 2022-2024.
- One of the three priorities outlined by the ECB is to tackle emerging risks, including climate-related and environmental risks.
It is essential for banks to act relatively quickly and demonstrate their commitment to tackling these risks. As noted above, this year, the ECB will conduct a thematic review and stress test of C&E risk, with the goal being to integrate these into the Supervisory Review and Evaluation Process (SREP) methodology. This will ultimately affect institutions Pillar 2 requirements. While the ECB acknowledges this is an area currently evolving, there is still a need for these expectations to be met.
Below, we discuss some important considerations from the above documents regarding risk management and C&E risks. Firstly, look at risk management frameworks overall, then turn our attention to individual risk areas such as credit, operational, liquidity and market based. From there, we will touch on stress testing and scenario analysis and finally discuss disclosures.
Risk management framework
It will need to go beyond qualitative factors to gain meaningful insight as part of the materiality assessment process. Institutions should use available proxies and estimation techniques to quantify the materiality and impact on the business. This may enable a comprehensive framework from which to set a level of risk appetite and monitor the C&E risks evolution.
Quantitative Indicators can include but are not limited to:
- Physical risk at the sector level
- Flood risk indicator at the client level
- Energy certificate
- Transition risk at the sector level
Where risk drivers are difficult to quantify, an effort is needed to develop qualitative proxies outlined in the “ECB Guide to the internal capital adequacy assessment process (ICAAP)” from November 2018. Any proxies developed should be documented transparently that define the indicators and data used to develop these clearly. A reporting framework could consider a three-pronged approach, including data gap analysis, data collection and data management and reporting.
The CBI has made it clear that firms are expected to “understand the impact of climate change on the risk profile of the firm and to enhance their existing risk management frameworks to ensure climate risk identification, measurement, monitoring and mitigation”. This definitive statement indicates that CBI expects firms to integrate C&E risks throughout the risk management framework.
Credit risk management
Credit risk has been identified as the area most exposed to C&E risk drivers by significant institutions. By introducing enhanced due diligence procedures and dedicated climate questionnaires, banks will obtain more climate-related data and, in turn, a clearer picture. Lending policies are also being adapted to include exclusions and phasing out processes of certain types of lending. Other factors to consider include:
- Geographical location is of key importance when identifying real estate in areas exposed to physical risks.
- The incorporation of quantitative C&E risk factors into banks probability of default models should be considered.
- The use of sectoral analysis to identify concentration risk is imperative to avoid over exposure to physical and/or transition risk when monitoring portfolios.
Operational risk management
It should be considered how C&E risks and future events could pose litigation, liability and reputational risks. There is an ever-increasing focus from stakeholders on emission reduction targets and financing extended to sectors with high rates of pollution. Continued levels of lending to these sectors have an inherent reputational risk but also could lead to a reduction of the client base. The compliance function should be utilised to assess pending regulations in this area to determine possible impacts. Consideration should be given to initiating a comprehensive review of processes to ensure the appropriate governance of transactions that could involve climate and environmental concerns.
Liquidity risk management
Extreme C&E events pose a significant threat to liquidity and therefore natural disasters should be integrated into liquidity contingency plans. Greenwashing is another potential threat. C&E risks should at least be integrated with regular liquidity stress testing or the ILAAP exercise. The impact on the Liquidity Coverage Ratio (LCR) buffer from the threat of greenwashing can be measured by an effectively designed stress test scenario.
Market risk management
Market risk policies and processes should be updated to include C&E risks. These should also be incorporated into market risk measurement metrics and portfolio monitoring and analysis. Limiting market risk exposure to sectors deemed non-ESG compliant can be implemented in a phasing out approach, reducing exposure in a timely fashion. Implementing newly updated policies and processes with respect to market risk should not be limited to market risk arising from the trading book but should account for the banking book also. Effective phasing-out criteria and exclusion of certain business activities should be considered.
Stress testing and scenario analysis
C&E risks should be integrated into regular stress testing frameworks. Physical risks such as floods or droughts are well defined; however, transition risk can be difficult to define. Transition risk scenarios could include the impact on the global economy of alignment with the Paris Agreement in either an orderly or disorderly fashion. These are more generally economy-wide scenarios as opposed to institution-specific.
For the Climate Stress Test that banks must submit from March of this year, the macro-financial scenarios are prepared to reflect possible future climate policies and assess both physical risk and a transition to a greener economy.
In January 2022, the EBA published the implementing technical standards (ITS) on Pillar 3 disclosures on ESG risks. The European Commission has adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD). This Directive envisages the adoption of EU sustainability reporting standards. These are being developed by the European Financial Reporting Advisory Group (EFRAG)
A disclosure policy should describe definitions that support policy, including:
- Methodology standard used.
- Step by step description of preparation.
For each step, the policy should allocate the corresponding roles, responsibilities and tasks to the organisational units involved.
This article was first published in the Finance Dublin Yearbook 2022.